Academic journal article Atlantic Economic Journal

The Global Financial Crisis in Transition Economies: The Role of Initial Conditions

Academic journal article Atlantic Economic Journal

The Global Financial Crisis in Transition Economies: The Role of Initial Conditions

Article excerpt

Introduction

The main objective of this paper is to investigate the effect of the Global Financial Crisis of 2007-2009 on the countries of the former Soviet bloc and to set a new direction for research in this area. The opening of financial markets to foreign capital, financial liberalization, and integration into global markets, while stimulating economic growth, promoted greater dependency on exports and capital inflows, making these countries more vulnerable to external financial shocks. The Mexican crisis of 1994, the East Asian crisis of 1997-1998, the Russian crisis of 1998, and the Argentinean crises of 2000 and 2003 collectively decreased the former soviet bloc region's gross domestic product (GDP) by over $400 billion (European Bank for Reconstruction and Development 2009). Since the inception of the transition, no other event has affected these economies as much as the Global Financial Crisis of 2007-2009. The collapse of the subprime mortgage industry in the U.S. and subsequent severe recession triggered a wave of financial and economic shocks that spread to Europe and to other parts of the world, affecting both developed and emerging markets. The severe slowdown in economic activity in emerging economies was a result of a virtual stop of foreign credit flows and a drastic decline in exports (Reinhart and Rogoff 2009; Ozkan and Unsal 2012).

The impact of the crisis, however, varied widely across the transition area. (1) In the beginning, only the Baltic states and a few Central Eastern European (CEE) countries were affected. Most other transition economies were enjoying a surge in domestic credit (especially in the Caucasus region) and were reaping the benefits of the high volume of capital inflows (European Bank for Reconstruction and Development 2010). By the end of 2008, the whole region was in a sharp downturn. At the height of the crisis, cumulatively during the fourth quarter of 2008 and the first quarter of 2009, output contracted on average by some 6.5% in the transition countries and 12.5% in the Baltic region (European Bank for Reconstruction and Development 2009). Gross fixed capital formation dried up completely in 2008 and became negative in 2009 in all regions except Central Asia. Likewise, credit to the private sector continued to shrink and unemployment soared across the entire region (European Bank for Reconstruction and Development 2010). In 2009, Estonia (already in recession at -3% in 2008) contracted to -10.5%, Lithuania -11.8%, Latvia -13.2%, Russia -7.5%, and Ukraine -10% (European Bank for Reconstruction and Development 2009).

In addition, households in transition economies were more likely to hold their deposits and loans in foreign currency and thus were more exposed to exchange rate risk. The Baltics and Ukraine had the highest foreign currency exposure of household debt, with foreign-currency-denominated loans accounting for over 80% of bank loans to households in Estonia and Latvia (Tiongson et al. 2010). Once the crisis hit, depositors became concerned about the safety of their savings. Given weak and in some cases non-existent bank deposit insurance, depositors began to withdraw their money from the banking system. Additional pressure on the banking system stemmed from the fall in prices of real estate, which often served as collateral for lending. The drastic fall in property prices (that followed the rapid surge prior to the crisis and boosted a pre-crisis GDP in many transition economies) contributed to the severe growth shocks in the region (Stepanyan et al. 2010).

Currencies in most transition economies fell by approximately 20%, which aggravated the debt issues. Following the differences in currency regimes prior to the crisis, exchange rate policies were rather diverse. Bulgaria, Estonia, the Former Yugoslav Republic (FYR) Macedonia, Latvia and Lithuania, maintained their hard pegs, while Armenia, Belarus, Georgia, Kazakhstan and Russia undertook step devaluations (European Bank for Reconstruction and Development 2009). …

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